Third-party releases have become a common and oft-litigated issue in connection with confirmation of a Chapter 11 plan. This is especially so if the party being released is the target of claims arising out of questionable prepetition transactions. And although rare and usually reserved for special circumstances, releases of third parties have been granted to a non-debtor on a nonconsensual basis if the contribution by the non-debtor party to the bankruptcy case is significant.

A recent decision by the federal Delaware district court in Millennium Lab Holdings, however, sets another roadblock to the bankruptcy court’s authority to approve nonconsensual  third-party releases. See Opt-Out Lenders v. Millennium Lab Holdings II, LLC (In re Millennium Lab Holdings), No. 16-110-LPS, 2017 WL 1032992 (D. Del. Mar. 20, 2017).
The district court in Millennium found that even where a bankruptcy court might have jurisdiction to approve plan-based third-party releases, it may lack constitutional authority to approve those releases on a nonconsensual basis. The remand of the district court’s decision was recently heard by Judge Silverstein of the Delaware bankruptcy court, and a decision is forthcoming.

Background

Before commencing its bankruptcy cases, Millennium Lab Holdings — a provider of laboratory-based diagnostic testing services — was the subject of a multiyear investigation by the Department of Justice (DOJ) into its billing practices and issues of Medicare fraud. While the  investigation was ongoing, Millennium consummated a dividend recapitalization in 2014, whereby it borrowed $1.825 billion in secured debt, $1.3 billion of which was immediately transferred to its equity sponsors (TA Millennium, Inc. and Millennium Lab Holdings, Inc.) as a dividend.¹ A year later, in mid-2015, the company reached a $250 million settlement of the DOJ’s Medicare fraud investigation and negotiated the terms of a restructuring of its debt with a majority of its secured lenders. The negotiations culminated in the filing of prepackaged Chapter 11 cases in November 2015. The Chapter 11 plan filed by the Debtors contemplated a $325 million contribution to the bankruptcy estates from the equity sponsors in exchange for a “full release and discharge” of all claims arising prior to the petition date, including claims that could be brought by third parties relating to the dividend recapitalization.

The day before plan confirmation, a minority group of secured lenders commenced an action in Delaware federal district court against the equity sponsors alleging, among other things, fraud, deceit, and intentional misrepresentation and violations of the Racketeer Influenced and Corrupt Organizations Act (RICO). The minority lenders also challenged plan confirmation on the grounds that the plan inappropriately provided for a nonconsensual third-party release of claims against the equity sponsor, including the claims being pursued by the minority lenders, and challenged the court’s jurisdiction to approve such releases. Days later, the bankruptcy court overruled the minority lenders’ objection and confirmed the Debtors’ plan. In ruling on confirmation, the court found that it had “related to” subject matter jurisdiction over the minority lenders’ claims and found the release of those claims appropriate. The bankruptcy court did not, however, address whether it had constitutional authority to issue a final order releasing the claims against the equity sponsors. 

The minority lenders appealed, arguing that they had a constitutional right to have their common-law claims adjudicated by an Article III judge, and that the bankruptcy court’s nonconsensual release of those claims was unconstitutional. The Debtors argued that the plan had been substantially consummated and could not be unwound without losing the $325 million contribution, thereby rendering the appeal equitably moot. The Debtors further argued that the bankruptcy court had both jurisdiction and constitutional authority to approve a plan with nonconsensual third-party releases, and even if it did not, the district court could review and approve the confirmation order de novo, mooting the minority lenders’ appeal.

Subject Matter Jurisdiction and Constitutional Authority

Federal district courts are established pursuant to Article III of the Constitution, and litigants are given the constitutional right to have their common-law claims adjudicated by an Article III judge. Bankruptcy courts, in contrast, are established under Article I of the Constitution and are automatically referred any proceedings arising under or related to a bankruptcy case by the district court pursuant to 28 U.S.C. § 157(a). By statute, bankruptcy courts are given the authority to render final judgments on “core” matters; i.e., orders in “cases under title 11” and “proceedings arising under title 11, or arising in a case under title 11.”  See 28 U.S.C. § 157(b). For matters that are only “related to” a bankruptcy case, the bankruptcy court is limited to hearing the matter and proposing findings of facts and conclusions of law to the district court for its de novo review and determination. 

In Stern v. Marshall, the Supreme Court added another layer of complexity to the core/non-core analysis by distinguishing between the bankruptcy court’s statutory and its constitutional authority to render a final determination on certain claims. 131 S. Ct. 2594 (2011). The Supreme Court found that for a non-Article III judge to have constitutional authority to adjudicate a claim (separate from statutory authority), the claim must involve matters of “public rights.” In the bankruptcy context, “public rights” applies to claims that “stem [] from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” Id. at 2618. Thus, under the facts of Stern, even though an estate’s defamation counterclaim is a “core” matter by statute, the Supreme Court found that the bankruptcy court did not have constitutional authority to adjudicate the claim because it arose under stat